Recent Bankruptcy Court Decisions Address Bankruptcy Code Section 365

Section 365 of the Bankruptcy Code provides that a debtor “subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.”  11 U.S.C. § 365.  This provision is a powerful tool because it allows a chapter 11 debtor to assume agreements that will be beneficial to restructuring efforts while rejecting agreements that are burdensome.  Given its importance, the application of section 365 is not without challenge and subject to interpretation.

Two recent bankruptcy court decisions, In re Cho, 581 B.R. 452 (Bankr. D. Md. 2018) and In re Thane International, Inc., No. 15-12186-KG, 2018 WL 1027658 (Bankr. D. Del. Feb. 21, 2018), examine the fundamentals of executory contracts — when a contract is “executory” and whether there can be an “implied” assumption and assignment of an executory contract.

In re Cho

Considering whether a prepetition settlement agreement was an executory contract that could be rejected, the Maryland bankruptcy court, in Cho, observed: “whether a contract is executory depends on the facts of the particular matter, the language of the subject agreement, and the consequences under applicable nonbankruptcy law of either party ceasing to perform any ongoing or remaining obligations under the contract.”  Cho, 581 B.R. at 454.

In Cho, the debtors were defendants in state court litigation prior to filing bankruptcy.  Id.  The parties to the state court litigation agreed to a settlement that was reduced to writing, but the defendants refused to sign and maintained that the plaintiffs violated a certain non-disparagement provision in the settlement.  Id.  The state court ruled that there was a valid agreement and compelled the parties to execute the agreement.  Id.  Thereafter, the defendants filed for chapter 11 relief and moved to reject the settlement agreement as an executory contract under section 365 of the Bankruptcy Code.  Id.

Based on the facts and state court ruling, the bankruptcy court initially determined that there was a valid and enforceable contract under Maryland law.  Id. at 460.  Then, the court considered whether the contract was an “executory contract” for purposes of rejection under section 365 of the Bankruptcy Code.  Id. at 461.  Applying the Countryman test, the court evaluated whether both parties had unperformed obligations under the contract, which if not performed would result in a material breach of the contract.  Id.  Under the settlement agreement, the debtors were required to, in part, transfer a dry-cleaning business to the plaintiffs and make a cash payment.  Id. at 462-463.  The plaintiffs were required to dismiss litigation and note a certain judgment was satisfied.   Id. at 463.  In addition, both parties had non-disparagement obligations.  Id.

The main issue for the court was whether the obligations, and in particular the plaintiff’s obligations, were material under Maryland law.  Id. at 462.  The court noted this question depended on the primary purpose of the contract, which the court found to be settling the litigation and providing finality and certainty to the parties, and the non-disparagement provision bolstered and served this purpose.  Id. at 463-464.  Accordingly, the court held that the agreement could be rejected as an executory contract and the record supported the debtors’ business judgment and request to reject.  Id. at 466.  The court also observed that rejection generally does not eviscerate the non-breach party’s state law rights under the contract but any nonbankruptcy rights that the plaintiffs retain do not include the right to request specific performance of the agreement.  Id. at 467-68 citing Newman Grill Sys., LLC v. Ducane Gas Grills, Inc., 320 B.R. 324, 337 (Bankr. D. S.C. 2004).

In re Thane International

 In Thane, Delaware bankruptcy court considered “whether an executory contract that was neither affirmatively assumed nor rejected was included and assigned in a sale transaction.”  Thane, 2018 WL 1027658 at *1.  In Thane, the court had approved a sale of substantially all of the debtor’s assets under section 363 of the Bankruptcy Code.  Id.  A contract with a producer of informercials was not included as a contract to be assumed and assigned as part of the sale.  Id. Several months after the sale closed, the producer filed suit against the purchaser alleging it was owed royalties under a production agreement with the debtor.  Id.  The producer argued that the purchaser’s post-closing conduct and use of the contract effectuated a valid assumption and assignment of the contract.  Id. at *4.  The purchaser moved to dismiss the action on the basis that the producer failed to “distinguish pre- and post-closing royalties” and argued, in part, that an assumption and assignment did not occur because the “strictures” were not met, and “course of conduct cannot substitute.”  Id. at *1 and 2.

The bankruptcy court rejected the producer’s argument that the purchaser’s course of conduct constituted an implied or tacit assumption.  Id. at *6.  The court held that “there is no assumption” of an executory contract “absent a motion” as required under section 365 of the Bankruptcy Code.  Id.  In so ruling, the court observed that “there simply cannot be an assumption without providing the necessary cure and adequate assurance of one”, which the producer did not receive.  Id. at *7 citing 11 U.S.C. § 365(b)(1)(A)-(C).  As summarized by the court, section 365 allows a debtor “to do three things with an executory contract: (i) reject it, (ii) assume it or (iii) assume and assign it.”  Thane at *10.

The Cho and Thane decisions provide helpful guidance in determining whether an agreement is executory and a debtor’s options under section 365.  Cho is a reminder of the power of section 365 to a debtor while Thane is a reminder to adhere to the Code’s procedural requirements to obtain the benefits of section 365.